Why Are Stablecoins Becoming Popular?

As cryptocurrency markets lurch from volatility to scandals, the ecosystem for stablecoins has exploded. Prominent names and startups alike have announced stablecoin projects. For example, the Winklevoss brothers, who are already pioneers in cryptocurrency investing, recently announced the launch of Gemini dollar, a stablecoin designed for their trading platform Gemini. Technology giant IBM Corp. (IBM) has also jumped into the market by partnering with Stellar blockchain.

Why Are Stablecoins Popular?

While other coins routinely traverse steep increases or decreases in their price movement, stablecoins trade at parity with fiat currencies, notably the US dollar. Their popularity in the current cryptocurrency ecosystem is a function of two factors.

First, they stabilize an otherwise volatile cryptocurrency ecosystem.

Stablecoins are unlike conventional cryptocurrencies because they do not have a limited supply or fixed schedule. Instead, they are disbursed based on market conditions and economics. They are also backed by collateral to safeguard investors from a crash in the markets. For example, Tether claims to have as many dollars in an unspecified bank account as there are Tether coins in circulation. This approach helps it to trade at parity with fiat currencies. The absence of volatility in prices also means that stablecoins can also be used to purchase items or exchanged with fiat currencies or other cryptocurrencies. The latter use is already popular at exchanges like Bitfinex, where Tether functions as the cryptocurrency exchange’s token for beginner investors. The first step to purchasing cryptocurrencies at the exchange is buying Tether, which trades at parity with US dollar. Subsequently, the coin can be used to buy other cryptos. There are those who believe that stablecoins might also fulfill the original promise of cryptocurrencies by becoming a medium of daily transaction and unit of account.

The other factor influencing the growth of the stablecoin ecosystem is the influx of venture capital money into its ecosystem. The development may seem odd since the lack of volatility in stablecoin prices substantially reduces the chances for investors profits from price movement. But the emergence of new business models in their ecosystem offers the prospect of profits to venture capitalists and regular investors. (See also: Is A Stablecoin The Answer To All Problems In Cryptocurrencies?)

To date, three stablecoin models have emerged. The first one is similar to the Tether model in which a coin is backed by reserves of fiat currency. It would be difficult for investors to profit off this model.

The second model is a modified expansion of the first one. In the multi-asset collateral model, multiple assets are used to back the cryptocurrency. The range and type of these assets span a wide spectrum, from gold to fiat currencies to other cryptocurrencies.

MakerDAO’s DAI stablecoin, which holds smart contract reserves of ethereum’s ether in a 3:1 ratio (three ether for every dollar), is an example of this model. In addition, another token, MKR, is used for governance purposes. According to its founders, the DAI token can be used in multiple markets, such as prediction markets and gambling. This will increase its velocity and make it more valuable. Investment in the DAI stablecoin also translates into an investment into the underlying assets used to stabilize its price. In turn, this could translate into profits.

The third type of stablecoin model is a coin whose stability is underpinned by the economics of bond markets. Basecoin, backed by Andreessen Horowitz, is an example of this kind of coin. The coin is backed by bonds, also known as Basebonds, which are used to contract and expand its market supply. The bonds pay out dividends in the form of Share tokens, where 1 Basecoin = one bond token. The latter can be redeemed when the cryptocurrency’s blockchain produces more coins in response to market conditions.

The Problems With Stablecoins

But, there are still unanswered questions about stablecoins. The most important one relates to the effectiveness of their economics. With the exception of Tether, it is difficult to name a stablecoin which has been tested in real-world conditions. As such, there is a question mark regarding their practical implementation. Barry Eichengreen, economist at UC Berkeley, highlighted more design problems for stablecoins in a Guardian post recently. The first one is the possibility of a bank run on low-priced bonds. If Basecoin’s network does not achieve sufficient growth, then the price of its bonds will go down. As they dip further, Basecoin’s bonds may eventually not find buyers and become worthless.

The second problem relates to multi-asset collateral backed coins. The coins may be forced to cover up a decline in value for one asset (say, a dip in ether prices) by increasing the value of its holdings in another asset to prop up its price. The cascading effect of such a strategy may eventually result in a bank run, a situation in which investors flee from an asset that is declining in value.

Investing in cryptocurrencies and other Initial Coin Offerings ("ICOs") is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or other ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein.

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